Public Finance and Public Policy: Responsibilities and Limitations of Government
Arye L. Hillman
Cambridge University Press, 2009
Second edition
Presentation notes, chapter 4
PUBLIC FINANCE FOR PUBLIC GOODS
Hillman, 2009: Public finance for public goods
2
Societies cannot rely on voluntary payments for prisoners-dilemma public goods and governments are called upon to levy taxes to finance public goods.
o We cannot rely on the Tiebout mechanism to reveal information about preferences because people with different preferences reside in the same jurisdiction
o We cannot rely on the Clarke tax
o Governments do not know subjective benefits ∑MB that
public goods provide to the people in a population
o Asymmetric information remains
Hillman, 2009: Public finance for public goods
3
We set aside political and bureaucratic principal-agent problems We hope that governments have been successful in using cost-benefit analysis to approximate efficient public spending
We shall not now ask normative questions about the desirable structure of taxation The question is positive: What are the consequences of using public finance to provide public goods?
Hillman, 2009: Public finance for public goods
4
The advantage of government:
Governments can resolve the free-rider problem by making payment for public goods compulsory through taxes
Hillman, 2009: Public finance for public goods
5
4.1 TAXATION
A. Efficient tax-financed public spending
The excess burden of taxation arises for both direct and indirect taxes:
A direct tax is paid when income is earned
An indirect tax is paid when income is spent
Hillman, 2009: Public finance for public goods
6
The excess burden of an income tax The excess burden BEC is revealed by asking the individual one of the following two questions:
(1) How much are you prepared to pay the government, in return for the government not levying the tax on you?
(2) How much does the government have to give you to compensate you for the tax that has been levied?
The excess burden of taxation
Hours worked O L1
J H
L2
Wage
w(1 – t)
A
D
E B
C
SL
w
Tax revenue
Excess burden
Pre–tax wage
Labor supply with substitution effect only
Hillman, 2009: Public finance for public goods
7
When there is only a substitution effect, and no income effect, the answer to the questions is the same: area BEC
The tax has imposed a greater cost than the money paid in taxes
No sum of money equal to the excess burden of taxation changes hands. The excess burden of taxation is invisible.
When the supply-of-labor function SL is linear, the area BEC is a triangle and the excess burden of taxation is
212 SLw L t
Measurement of the excess burden of taxation requires knowing the elasticity of labor supply SL
Hillman, 2009: Public finance for public goods
8
The elasticity of labor supply The previous figure showed a special case where SL = 1 The elasticity of labor supply can be constant or variable, depending on the form of the labor supply function.
A labor-supply function with an increasing elasticity of labor supply
Labor supply with substitution effect only
Wage
Hours worked O
SL
1
2
Hillman, 2009: Public finance for public goods
9
The excess burden of taxation increases with the square of the rate of taxation An increase in the tax rate from t1 to t2 increases the excess burden of taxation from B1EC1 to B2EC2.
The excess burden and the rate of taxation
Labor supply with substitution effect only
D1
D2
H
Hours worked
Wage
E
B1 B2
C1
C2
O
SL
w
w(1-t1)
w (1-t2)
Pre–tax wage
A
Hillman, 2009: Public finance for public goods
10
The case of SL = 0
Taxation with no excess burden
Labor supply with substitution effect only
Wage
Hours L O
SL w
w(1-t)
Hillman, 2009: Public finance for public goods
11
Intrusion into other markets
The excess burden of taxation arises because payment for public goods is not taking place in the market for public goods There would be no excess burden if public goods were voluntarily financed in markets for public goods: payment would then be taking place in the same market in which the goods are supplied.
Hillman, 2009: Public finance for public goods
12
An indirect tax (sales tax)
The excess burden of taxation when income is spent
εD = the individual’s elasticity of demand The excess burden of the tax BEC is
212 Dpq t
D C P
A P(1+ t)
q1 q2
MBi
E
B
Quantity O
Price
Pre-tax price determined in a competitive market
Tax revenue
Excess burden
Hillman, 2009: Public finance for public goods
13
Substitution effects and the excess burden of taxation
In the labor market, the individual is a seller (or supplier of labor services) and the substitution response to a tax is expressed through the supply elasticity In the case of a sales tax, the individual is the buyer and the substitution response is expressed through the demand elasticity
Hillman, 2009: Public finance for public goods
14
A value-added tax A value-added tax is an indirect tax, like a sales tax The tax base
o For a sales tax, the value of goods sold (and therefore bought)
o For a value-added tax, value-added at different stages of production
The virtue of the value-added tax compared to a sales tax:
o The value-added tax does not depend on the structure of ownership of productive activities
o A value-added tax makes income tax evasion difficult International trade: the value-added tax can be levied on imports so that foreign intermediate goods have no advantage over domestic output and can be rebated for exports
Hillman, 2009: Public finance for public goods
15
Use of the value-added tax o A value-added tax is the common indirect tax outside of the
U.S. o In the U.S. individual state governments levy sales taxes: a
value-added tax would require a complex administrative tracking procedures
o Similar problems arise if governments in a union such as the European Union levy their own value-added taxes
Hillman, 2009: Public finance for public goods
16
An excise tax
o Excise taxes are higher than general rates for sales and value-added taxes
o The taxes are usually levied on goods for which demand is
perceived to be quite inelastic, such as alcohol and tobacco
o The low demand elasticities suggest goods that are habit-forming or addictive
o The low elasticities give rise to low substitution effects and so
there are low excess burdens of taxation
Hillman, 2009: Public finance for public goods
17
Other costs of taxation The excess burden is accompanied by other costs of taxation Compliance costs Administrative costs Emotional costs of taxation
Rent seeking
The administrative costs associated with taxation reflect rent-seeking behavior – or behavior intended to change or prevent change to distribution
We proceed by focusing on the excess burden of taxation How does the excess burden of taxation affect efficient publicly-financed public spending?
Hillman, 2009: Public finance for public goods
18
Cost-benefit analysis and the excess burden of taxation How does the excess burden of taxation affect cost-benefit analysis?
X is the total excess burden incurred in collecting tax revenue. The cost-benefit rule for justifying public spending is:
1
0n
jj
W B C X
Efficient tax-financed public spending requires:
( ) ( )i G Xi
MB MC inputs for the public good MC theexcessburden
Hillman, 2009: Public finance for public goods
19
MCX is the marginal excess burden of tax-financed public spending
R t( wL )
1 SLdR wL.( ).dt
We proceed with εSL <1 because a government would not knowingly increase the tax rate if more tax revenue were not obtained
Hillman, 2009: Public finance for public goods
20
View εSL as constant
1 . .2 SLX R t
The average excess burden per dollar of tax revenue is
12 SL
X tR
For any rate of taxation t, the average excess burden increases with the labor-supply elasticity εSL
Hillman, 2009: Public finance for public goods
21
The average excess burden of taxation for two elasticities of labor supply εSL > εSL
The average excess burden of taxation (per dollar of tax revenue)
Tax rate
Excess burden per dollar of tax revenue
O
½εSL
½εSL
1 > εSL > εSL
t
Hillman, 2009: Public finance for public goods
22
MCX is the marginal excess burden
0 11 1
X SL
SL
tMC where
With εSL <1 and constant:
The marginal excess burden MCX is linear and is increasing the tax rate t
Hillman, 2009: Public finance for public goods
23
Comparison between tax-financing and voluntary payment
GE
TAX = finance by compulsory tax
GE = voluntary payment according to true benefit
GETAX < GE
Because of the excess burden of taxation, efficient tax-financed spending on public goods is less than efficient voluntary spending
GETAX GE
Quantity of the public good
MCG=P (cost of inputs only)
MCG+MCX (marginal cost of inputs plus marginal excess burden of taxation)
∑MB
O
Valuation and cost
Hillman, 2009: Public finance for public goods
24
Accountability and transparency of public spending
Accountability and transparency require the government budget to include the excess burden of the taxes that finance public spending
Hillman, 2009: Public finance for public goods
25
Are taxes available that have no excess burden? A tax with no substitution response is called a lump-sum tax Taxation of goods with no substitution effects
A life-preserving medication has completely inelastic demand A tax on essential goods or services is politically unwise
Addiction and taxes Addiction ensures the tax base The excess burdens of the taxes are low
Hillman, 2009: Public finance for public goods
26
Tiebout locational choice and taxes
The Tiebout locational choice mechanism is an application of the benefit principle of taxation
There would be no excess burden if the taxes paid to governments through voluntary locational choice were analogues of voluntarily paid market prices
Local public goods are in general not financed according to the benefit principle but through property, income, and sales taxes that have excess burdens
Often the principal tax for financing local public goods is a property tax on improved land: this is a tax on adding to the value of a property through further investment
The substitution response to the tax is that investment is undertaken elsewhere in other lower-tax jurisdictions
Substitution responses also occur through allowances in the tax code for depreciation
Hillman, 2009: Public finance for public goods
27
Taxes on unimproved value of land and Henry George Taxes on the unimproved value of land have no excess burden Land is trapped within a tax jurisdiction with no substitution
response that allows “escape” from the tax
Henry George (1839 - 1897) proposed that there should be only a single tax levied on the tax base of the unimproved value of land
George did not make his case on efficiency grounds due to the absence of an excess burden
His case was based on social justice He observed that people who owned land benefited when economic growth increased the value of land, yet landowners had done nothing productive to merit the increase in their wealth
Hillman, 2009: Public finance for public goods
28
A poll tax A poll tax is a payment for the right to vote If all citizens choose to exercise their right to vote, poll taxes are lump-sum taxes Poll taxes impose a cost of voting By determining who votes, a poll tax can affect political decisions about public finance and public policy
Hillman, 2009: Public finance for public goods
29
A personal head tax A personal head-tax is a lump-sum tax with no substitution effect
The head-tax can depend on nothing other an individual’s existence and identity
The head-tax cannot depend on any attribute or behavior that a person can change – income, purchases, wealth, number of dependents, or marital status, personal ability (which people can hide)
There is scope for unfairness because different people can arbitrarily be assigned different taxes
The only escape from a head tax is to leave the jurisdiction of the government levying the tax
Head taxes would not be politically popular
In civil societies, taxes are levied on the market-determined value of a person’s income or the market-determined value of property and not according to people’s inalterable identities
Hillman, 2009: Public finance for public goods
30
The unavailability of taxes with no excess burden Other than taxes on unimproved value of property, taxes without an excess burden are not feasible, or not ethically or politically desirable
Taxes without an excess burden are generally not used
Hillman, 2009: Public finance for public goods
31
Measurement of the excess burden of taxation
Invisibility of the excess burden of taxation makes measurement difficult: the excess burden cannot simply be observed and directly measured Surveys are unlikely to yield reliable information Estimation from aggregate market data Two types of problems (1) There are taxes with no tax revenue
The excess burden (which is invisible in the first place) may be invisible in a market that no longer exists.
(2) Taxes in one market result in excess burdens in other markets.
The excess burden of a tax in the market where the tax is levied understates the excess burden of taxation because of responses in other markets.
Hillman, 2009: Public finance for public goods
32
A tax with an excess burden
and no revenue
The change in the
excess burden in market 2 when the tax changes in market
1
E2
O
C1
B1
E1
Excess burden
Quantity of good 2
Price of good 2
Supply good 2
Demand for good 2 BEFORE the tax on good 1
Demand for good 2 AFTER the tax on good 1
B2
C2
Hours worked
O
Wage
B E
SL
w
Excess burden
Pre–tax wage
L1
Hillman, 2009: Public finance for public goods
33
Measuring the excess burden in labor markets The value of the labor-supply elasticity depends on Possibilities for marginal adjustments to labor supply The decision whether to work for a living (when hours worked
are not flexible, the choice is between having and not having a job)
Payments provided by governments to people who do not work
Obligations outside the labor market
Hillman, 2009: Public finance for public goods
34
Diversity in empirical estimates of the excess burden Example: In the United States, estimates of the marginal excess burden of taxation have ranged from 7 cents to 39 cents. Tracing effects through other markets suggests higher values. Why is there diversity in estimates? Difficulties of accurately measuring something that is invisible tracing through effects in the different markets in an economy taking into account both adjustments in hours worked and the
decision whether or not to have a job accounting for the effect of income received from the
government when not working Scope for discretion and assumptions
Flexibility in assumptions can result in estimates that are influenced by predisposition regarding size of government
Hillman, 2009: Public finance for public goods
35
Evidence on the excess burden from social experiments Under communism, people were asked (or compelled to) behave as if their personal elasticity of labor supply were zero
The principle was
People should contribute according to their ability and not according to personal reward.
The natural experiment persisted over decades and over generations The social experiment resulted in significant excess burdens “We pretend to work and they pretend to pay us”
Hillman, 2009: Public finance for public goods
36
B. Tax revenue and the Laffer curve
Tax revenue is:
R t( wL ) { tax rate }.{ taxbase }.
w=gross market wage, constant for any number of hours worked
Based on the substitution effect:
The tax base contracts when the rate of taxation increases.
Tax revenue increases if the increased tax rate more than compensates for the contraction of the tax base
1 SLdR wL.( ).dt
Hillman, 2009: Public finance for public goods
37
The elasticity of labor supply and tax revenue
The inverse slope of the labor-supply function measures the value of the elasticity of labor supply SL
O
Tax rate t increases, net wage declines SL < 1
Ln hours worked L
Ln wage w
SL >1
S w
Slope=1, SL = 1
Labor supply with substitution effect only
100% tax rate Zero hours worked Zero tax revenue
Pre–tax wage Zero tax rate Zero tax revenue
Hillman, 2009: Public finance for public goods
38
The Laffer curve
On the wrong side of the Laffer curve, the same revenue can be obtained with a lower rate of taxation and so with a lower excess burden of taxation
We previously used SL < 1 on the grounds that governments would never knowingly set a tax rate on the wrong side of the Laffer curve.
Ro
Maximum revenue when εSL=1
t = 0% provides zero revenue for the government
εSL>1 εSL<1
t*
Tax revenue R
Tax rate t t2
t = 100% provides zero revenue for the government
O t1
Hillman, 2009: Public finance for public goods
39
Individual behavior and the aggregate Laffer curve
The aggregate Laffer curve reveals the tax rate that maximizes total tax revenue Individuals have their own personal labor-supply functions and labor-supply elasticities Values of the tax rate that drive individuals onto the wrong side of their personal Laffer curve differ for different people Tax rates that are sufficiently high drive some people onto the wrong side of their personal Laffer curves.
Hillman, 2009: Public finance for public goods
40
Investment and the Laffer curve There is a Laffer curve for taxation of capital
Taxes on returns from investment result in substitution effects: investment declines or capital moves elsewhere to other tax jurisdictions When capital leaves a tax jurisdiction, the marginal product of labor declines and the tax base for labor income contracts There is negative reinforcement on tax revenue: a tax on one factor of production reduces the tax base of the other factor
Hillman, 2009: Public finance for public goods
41
Tax evasion the Laffer curve
o Another reason for the Laffer curve is tax evasion where tax rates become too high
The political sensitivity of the Laffer curve
o Location on the Laffer curve is revealed empirically by changing the rate of taxation and observing the revenue response
o The Laffer curve is politically sensitive for people who prefer
high government spending because of the possibility that decreasing tax rates can increase government revenue
o Political sensitivity is compounded by the distinction between
the short and long-run Laffer curve
Hillman, 2009: Public finance for public goods
42
A leviathan government and the Laffer curve
o A leviathan government seeks the maximum point of the Laffer curve
o Information about the Laffer curve is not always precise
o A leviathan government is prone to straying onto the wrong
side of the Laffer curve
Hillman, 2009: Public finance for public goods
43
C. Who pays a tax?
Normative principles of just taxation are:
o Horizontal equity requires that people who are identical in income and other attributes face the same tax obligations.
o Vertical equity requires that people who are not identical in income and other attributes face tax liabilities that are just in accounting for the sources of individual differences.
Principles according to which taxes can be levied:
o The benefit principle of taxation: people who benefit from public spending should pay the taxes that finance the spending
o Ability-to-pay principle of taxation: people who can most afford to pay should pay taxes, without regard for personal benefit obtained from the taxes paid.
Hillman, 2009: Public finance for public goods
44
Governments need to be able to verify that taxes are paid by intended taxpayers
The effective incidence of a tax does not necessarily correspond to the legal incidence
Payment of a tax depends on substitution possibilities, not on legal incidence
P’S
PB = PS = PE
P’B
F
A J D’
O Q1 QE
V
G
H
E
S + TAX
S= ∑MC
Quantity
D
Price
Tax
Hillman, 2009: Public finance for public goods
45
The sharing of the excess burden Demand and supply elasticities determine
Effective tax incidence (who pay a tax) The sharing of the excess burden
Hillman, 2009: Public finance for public goods
46
Effective tax incidence when taxes have no excess burden
Substitution effects only
A tax paid by sellers
A tax paid by buyers
The side of a market (buyers or sellers) with no substitution responses pays the entire tax.
When one side of the market pays the entire tax, there is no excess burden of taxation.
P’S
P=P′B
D’
O
D
S
Quantity
Price D
O Quantity
S’
S
P = P’S
P’B
Price
Hillman, 2009: Public finance for public goods
47
Political pronouncements and taxation
Substitution effects determine who pays a tax and the sharing of the excess burden of taxation
Public policy pronouncements that imply effective tax incidence is determined by legal tax incidence indicate
Misinformation (the political decision maker does not know economic principles), or
Disinformation (the political decision maker hopes that others do not know economic principles)
L1 O
Demand for labor
LE
wE wB
wS
Tax
Hours worked
Supply of labor
Wage
Hillman, 2009: Public finance for public goods
48
Fiscal illusion and tax incidence
Fiscal illusion occurs when taxpayers are not aware they are paying taxes
The excess burden of taxation and fiscal illusion
o When there is fiscal illusion, people do not know that they are paying taxes but the excess burden of taxation is present
o The substitution response is a response to change in a relative price and not a response to the reason for the change
Political decisions o Political benefit from effective tax incidence requires
asymmetric information about who pays a tax o Because of fiscal illusion, political decision makers may prefer
indirect taxes
Fiscal illusion arises with bond financing (to be considered presently)
Hillman, 2009: Public finance for public goods
49
Economy-wide effects on who pays taxes Economy-wide (or general-equilibrium effects) of taxes affect how the excess burden is shared and who pays a tax Examples
o Factor prices and incomes o A sales tax on toothbrushes and incomes of dentists
To know who in the final analysis pays a tax and who bears the excess burden of taxation, governments need to be able to trace the effect of the tax throughout all markets.
Hillman, 2009: Public finance for public goods
50
D. Taxes on international trade
Import duties or tariffs are a form of indirect taxation
Import duties provide governments with revenue but in high-income countries the tax revenue is the incidental consequence of protectionist policies
The excess burden of an import tariff
J I
G A
∑MC Domestic supply
P* (1 + t)
N D C
B
∑MB Domestic demand
O
Price
Quantity
P*
Q1 Q2 Q4 Q3
Hillman, 2009: Public finance for public goods
51
A sales tax and a tariff
A sales tax provides the same tax revenue as an import tariff with a lower rate of taxation and a lower excess burden of taxation.
Costs of collection of revenue Costs of collecting revenue from taxes on imports are low compared to a sales tax
Hillman, 2009: Public finance for public goods
52
Where tax administration allows domestic taxes to be collected, the purpose of a tax on imports cannot be to provide tax revenue – since a sales tax is a better revenue instrument.
The purpose of a tax on imports is not revenue but to provide protectionist rents to domestic industry interests.
Hillman, 2009: Public finance for public goods
53
Why use an import tariff? If the objective is government revenue, a sales tax is preferable to an import tariff If the objective is protection, a subsidy to domestic producers provides the same rents to domestic producers as an import tax but with a smaller efficiency loss.
Why would governments choose to use import tariffs as means of providing protectionist rents to a domestic industry?
o Visibility in the government budget opens production
subsidies to scrutiny and debate. o An import tax provides protectionist rents that do not appear
in the government budget o Buyers provide the rents directly to the domestic industry,
through the higher domestic price directly paid to domestic producers
Hillman, 2009: Public finance for public goods
54
Import quotas The choice between tariffs and import quotas For a competitive domestic industry, the two policy instruments are equivalent – except for who obtains revenue
The quota creates rents for private individuals at the expense of government revenue.
The private profits from being assigned quota rents set in place a rent-seeking contest
Why would a government forego tariff revenue to create private rents through an import quota?
Hillman, 2009: Public finance for public goods
55
4.2 TAX EVASION AND THE SHADOW ECONOMY
A. Tax evasion as free riding
Tax evasion is illegal free riding in contributions to public goods.
o Tax evasion and tax incidence
o Public policy The expected penalty for being found to have evaded taxes is:
{probability of detection}.{penalty if detected}.
o Why do people evade taxes?
o Tax evasion and social norms
o Risk-averse behavior
Hillman, 2009: Public finance for public goods
56
Opportunities for tax evasion Opportunities for tax evasion are not uniform A property tax Employees and employers Sellers who deal directly with final purchasers Self-employed persons and employers or owners of small
businesses have opportunities for evading taxes by finding ways to understate revenues and overstate expenses
Estimates of underreporting for the United States
o One percent of incomes from wages and salaries o 4 percent of income from taxable interest and dividends o 57 percent of non-farm self-employed business income o 74 percent for farm income, under-reporting increases to 74
percent
Hillman, 2009: Public finance for public goods
57
Tax evasion and exchanges of services
Indirect taxes (sales taxes, excise taxes, and import tariffs) - complicity of corrupt cooperating customs inspectors.
Multinational firms and transfer prices
Illegal immigrants
Tax avoidance and tax evasion
There is injustice when some people can engage in tax avoidance and others only in tax evasion
Tax evasion does not incur the expenses of tax avoidance but is illegal and subject to penalties and stigma if detected.
Hillman, 2009: Public finance for public goods
58
Unequal opportunities to evade taxes are a source of social injustice because of arbitrary sharing of the tax burden and of the excess burden of taxation
Hillman, 2009: Public finance for public goods
59
B. The behavior of the tax authorities
How do the tax authorities behave toward taxpayers?
Presumptive taxation
Corruption in low-income countries
Hillman, 2009: Public finance for public goods
60
C. The shadow economy
In the shadow economy, incomes are entirely outside of the domain of taxation Tax evasion takes place in the shadow economy but also in the official economy.
Welfare fraud o People employed in the shadow economy declare themselves
to be officially unemployed and receive unemployment benefits or welfare payments
o They fraudulently take money from the government (i.e., from taxpayers) while at the same time evading taxes on their incomes in the shadow economy.
Hillman, 2009: Public finance for public goods
61
The size of the shadow economy The size of the shadow economy cannot be directly observed and therefore has to be inferred or estimated Researchers look for observed variables that are correlated with the size of the shadow economy – or that are correlated with the true size of national income including the shadow economy Money supply Extent of cash payments Use of electricity Differences between total income and total spending Differences between population size and people employed
indicated by official statistics. More complex approaches: A variety of indicators and causes are used to estimate the size of the shadow economy as an unknown variable
Hillman, 2009: Public finance for public goods
62
The size of the shadow economy as a proportion of reported official gross national product
1990 1995 2000 2005 Georgia 58 62 67 66 Ukraine 43 47 52 55 Russia 38 41 46 47 Turkey 26 29 32 33 Greece 23 29 29 26 India 23 25 Italy 23 26 27 23 Israel 16 19 22 23 Belgium 19 22 22 20 Portugal 16 22 23 20 Spain 16 22 23 20 Czech Republic
16 17 19 18
China 13 17 Norway 15 18 19 17 Denmark 11 18 18 16 Hong-Kong SAR
12 13 17 16
Hillman, 2009: Public finance for public goods
63
Sweden 16 20 19 16 Germany 12 14 16 15 Canada 13 15 16 14 Ireland 11 16 16 14 Australia 10 13 13 13 France 9 15 15 13 Netherlands 12 14 13 13 New Zealand
9 11 13 11
U.K. 10 13 13 10 Austria 7 9 10 9 Japan 9 11 11 9 Switzerland 7 8 9 9 U.S.A. 7 9 9 8
Source: Schneider (2005, 2007). Numbers are rounded up.
Corruption and the shadow economy
Hillman, 2009: Public finance for public goods
64
Reliability of the estimates
The incentive to claim exaggeration o A large shadow economy can be attributed to high taxation
and high public spending o Ideology can affect willingness to accept estimates that
reveal large shadow economies o Governments with large shadow economies may be politically
sensitive and object that estimates overstate the true size of their shadow economies
Hillman, 2009: Public finance for public goods
65
D. Inefficiency and illegality in a shadow economy
Injustice There is injustice when unequal opportunities for tax evasion result in discriminatory tax burdens Honesty is penalized: Activity in the shadow economy provides a cost advantage for producers who do not pay taxes
Inefficiency in the shadow economy The excess burden of taxation is reduced However, tax evasion is a source of inefficiency
o Limited scope for personal success o No recourse to courts for enforcement of contracts and to
settle disputes o The shadow economy invites corruption
Hillman, 2009: Public finance for public goods
66
Conspicuous consumption and visible spending
Money laundering
The Laffer curve and tax evasion
Hillman, 2009: Public finance for public goods
67
4.3 GOVERNMENT BORROWING
Bond financing of public spending is deferred taxation, including a deferred excess burden of taxation
A. Bond financing and the benefit principle of taxation
The normative rule based on the benefit principle of taxation is:
Current taxes should be used to finance current benefits from public spending
Bond financing should be used to match future benefits with future tax payments.
Hillman, 2009: Public finance for public goods
68
Bond financing for public spending
Period
1
Period
2
Period
3
TX=40
0
BX=80
0
TY=400
BY=400
TZ=40
0
BX=800
=TY+BY
BY=40
0=TZ
D1= -
800
D2=-
400 D3=0
Total cost: C=1200=TX+TY+TZ
Zero interest rate
Hillman, 2009: Public finance for public goods
69
Default on government bonds
o Generation Z could gain by reneging and refusing to transfer its share of the cost of the project to generation Y.
o The public project would continue to provide benefits o The project was completed in period 1 and the only change if
a government reneges on honoring bond redemption obligations is in intergenerational income distribution.
Sale of government bonds to foreigners
o Bonds can be sold to foreigners o The taxes to repay the bonds (and to pay interest on the
bonds) continue to levied on the different generations of domestic taxpayers
Hillman, 2009: Public finance for public goods
70
B. Intergenerational tax sharing
Bond financing can be manipulated to redistribute income among different generations
Ricardian equivalence
When the taxes of different people repay the bond, the choice between taxes and bond financing has distributional effects
Whether taxes or bond financing is used does not matter for an individual, if the same individual pays the taxes that finance interest and repayment of the government loan
Intergenerational altruism makes taxation and bond financing equivalent
When governments tax gifts or bequests, the intergenerational altruism that restores Ricardian equivalence is taxed
Hillman, 2009: Public finance for public goods
71
Future taxpayers Is present bond-financed public spending consistent with the preferences of future taxpayers? Asymmetric information: Only a future generation knows its own preferences for public spending
In practice, present generations have no choice but to make decisions on behalf of future generations Example of defense
o Defense spending provides a public good for the immediately threatened generation
o Future generations also benefit o It therefore seems reasonable that future generations should
pay part of the cost of ending the threat, through future taxes of bond financing
Hillman, 2009: Public finance for public goods
72
C. Fiscal illusion in bond financing
Do taxpayers know that bond financing implies future taxes? If so, do taxpayers accurately perceive the values of their
future tax liabilities due to bond financing? The compensating transfers required for Ricardian equivalence require positive answers to both questions Asymmetric information because of fiscal illusion
A political principal-agent problem allows government spending to exceed the spending that informed tax payers would want
Hillman, 2009: Public finance for public goods
73
D. Constitutional restraint on government borrowing
We have identified reasons why bond financing can be socially undesirable
o A government might favor contemporary taxpayers through bond financing
o If there is fiscal illusion, present taxpayers will find
themselves with higher tax payments (and excess burdens) in the future than they would have agreed to
A legal constitutional restraint can limit financing through government borrowing to benefits that each future generation receives from past public investment
Hillman, 2009: Public finance for public goods
74
A budgetary surplus We have been considering a government that requires revenue to finance spending Surplus revenue can be used: (1) to reduce present taxes (benefits present taxpayers) (2) to repay past government borrowing by buying back
previously issued government bonds (benefits future taxpayers)
(3) in ways that benefit particular groups rather than to take advantage of the surplus to reduce present or future taxes
The decision about how to use a government budget surplus is distributional and political
Constitutional restraint can also apply to government policies when there are budgetary surpluses
Hillman, 2009: Public finance for public goods
75
SUPPLEMENT
The excess burden with substitution and income effects
The analysis of the excess burden of taxation has been based on the substitution effects alone Taxes also have an income effect
The excess burden as payment to avoid a tax and compensation for a tax differ because of the income effect
Hillman, 2009: Public finance for public goods
76
The excess burden of a tax with income effects
1
5
H
D 2
3
4
A O
B
Y
Z
U2
Pre–tax relative price
ICC1 or income consumption curve (or line) showing changes in consumption as income increases at the pre-tax relative price
Quantity of X
ICC2 or income consumption curve (or line) showing changes in consumption as income increases at the post-tax relative price
Income (spending on all other goods)
Post–tax relative price